My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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Dinner Table Economics: What is GDP?

Updated: Nov 2, 2020

Introduction

I am introducing a series – “Dinner Table Economics” - to discuss commonly used economic terms and concepts that you increasingly hear these days, especially as the global economy reels from CV19. These terms are thrown around in the press regularly and perhaps absorbed without much thought. Therefore, it might be helpful to break some of these concepts down, and to explain how they are derived and their importance in helping us to make sense of the economy on a global scale. Even for those of you that know what the headline concept is, I hope that you will find these sorts of discussions interesting and informative.

I welcome your thoughts on these sorts of descriptive articles, which I will post periodically under the title “Dinner Table Economics”. The first topic I am covering in this paper is GDP.

What is GDP?

GDP is an acronym that means “Gross Domestic Product.”  GDP is a measure of the total goods produced and services provided within a country’s borders over a given period of time, usually monthly or quarterly.  The expenditure formula used for GDP is:

A couple of these categories might need explanation. The category “Investments” includes business investment in fixed assets (i.e. buildings, equipment, intangibles, etc.) and also consumer real estate purchases, but it does not include the purchase of financial assets likes stocks or bonds. “Net Exports” refers to the total amount of goods and services exported by a country, less the total amount of goods and services that are imported into a country. If the latter exceeds the former, then a country is running a trade deficit which – as an aside - is normally the case for the U.S. For many developed economies with non-centralised governments, consumption is usually the most important factor in the formula.

The U.S. had GDP in 2019 (4Q annualised) of $20.7 trillion, the largest in the word (25.1% of global GDP). Consumption accounted for 68% of GDP, investment 17%, government spending 18%, and net exports -3%, according to data from the Bureau of Economic Statistics (report here).


GDP is often used to compare the size of countries’ economies.  In this article, I will focus mainly on the countries (U.S., Japan and U.K.) and one economic bloc (E.U.) that I follow in emorningcoffee.com in the weekly report (last one is here), and will also include China because of its sheer size and growing influence in the global economy.

Comparing absolute GDP across countries

The table below shows the absolute GDP in US$-equivalent and the global ranking of the world’s largest economies. Global GDP in 2019 was estimated to be around $87 trillion. (For reference, the fifth largest economy in the world is India.)

Below are additional tables that provide a more granular look at GDP, including GDP for: i) the three largest U.S. states; ii) the three largest member-states of the E.U.; and iii) Canada as the only member of the G7 that is not included in the table above.

There are some interesting statistics in the table above. Firstly, the U.S. state of California has the fifth largest economy in the world, larger than the U.K. economy and larger than any country in the European Union except Germany. Secondly, the three largest countries in the E.U. account for nearly 47% of the economies of the entire bloc, a fair amount of concentration, and these countries – Germany, France and Italy – are all amongst the top eight largest economies in the world. Lastly, the G7 collectively had GDP in 2019 of $39.6 trillion equivalent, or just shy of 46% of global GDP.

GDP Trends

Trends in GDP growth are monitored over time by economists in order to compare the growth amongst countries and – more importantly – to monitor when an economy might be running “too cold” (i.e. under-capacity) or “too hot” (i.e. over-capacity). If a country’s growth is too slow, its economy might need stimulus from the government (fiscal) and / or central bank (monetary) to avoid a recession, normally meaning higher unemployment and idle production capacity. If a country’s growth is too fast, meaning that the capacity rate is too high, it can be equally problematic because this can lead to labour shortages and inflation. In this case, fiscal and / or monetary policy can be used to apply the brakes to the economy and slow its growth. Generally, the latter scenario has not been an issue in developed economies for many years.

For reference, a recession used to be defined as two consecutive quarters of negative GDP. Using this definition, it is clear now that most developed economies and many emerging economies are in a recession - 1Q20 GDP for many countries was negative, and it is certain that 2Q20 GDP for many of these same countries (China is an exception) will also be negative. However, the National Bureau of Economic Research – which declares recessions in the U.S. – had now adopted a broader definition of recession using more input factors, and it’s definition of a recession does not necessarily require that GDP growth be negative.

GDP can be measured by comparing one quarter to the quarter before, or by comparing a given quarter to the same quarter of the prior year (normally the case because this comparison takes into account seasonality). Make sure you are aware of the basis for a GDP growth figure when it is provided, so that you are comparing “apples to apples”. As an example, 1Q2020 real GDP (see next paragraph) in the U.S. was -1.28% when compared to 4Q19 (the quarter before), and +0.25% when compared to the same quarter from the year before (1Q19). However, the final reported figure for real GDP was -5.0%, which is roughly the growth rate between 1Q20 and 4Q19 annualised.

When GDP trends are examined over time, real GDP is used. Real GDP adjusts nominal GDP for inflation, stripping out price effects over time so production is isolated. Real GDP can also be referred to as “constant dollar GDP”. Such adjustments typically are more important of course in inflationary environments, and also make historical trends more relevant in analysing the economic growth for a country.

The graph to the left shows real quarterly GDP migration for the U.S., China, the Eurozone (19 countries sharing the Euro), Japan and the U.K. since 1980 (source: OECD). As the graph illustrates, the 1980s got off to a rocky start for the U.S. and the U.K. (both in recession), but was otherwise a decade of rapid GDP growth, especially for Japan. Since then, performance has varied by economy although the interconnectivity amongst economies is crystal clear when you look at the declines in major economies during the Great Recession (2007-09) and more recently during the current “manufactured” global economic shutdown to combat CV19.

In contrast to slower growing developed economies, the graph below shows the growth in the GDP of China since 1980, compared to the world average and to the U.S.

This graph clearly shows that China has had many years of impressive growth in real GDP, well above the growth of most countries in the world. However, it also shows the gradual slowdown of economic growth in China since 2010 as the country’s growth has started to converge slowly with the growth of developed economies like the U.S. Not dissimilar to the former graph, you can see that there is clearly correlation between the economies of China and the U.S., as far as trends, showing the interconnectivity driven by trade between the world’s two largest countries.

GDP/Capita

GDP per capita is simply the GDP of a country divided by the number of people living in that country. This is a much better indicator of how rich or poor a country’s population is compared to absolute GDP, although as some economists argue quite rightly, such comparisons do not account for non-monetary attributes of different countries including things like peoples’ happiness, work-life balance, and so on. With this limitation in mind, below is a table extracted from “Focus Economics” with the richest countries in the world by GDP/capita for 2019 and 2022, both projected at the time the table was created.

As the chart above illustrates, many of the most well-off nations in the world, at least measured by GDP/capita, are relatively small in terms of their population.


As far as larger economies in the world, the table to the right shows GDP/capita for the G7 countries, the Eurozone, the EU-27 and China at the end of 2018, the end of 2019, and if available, 1Q2020. It is expected that in the coming years, China will overtake the U.S. as the world’s largest economy as measured by absolute GDP. However, with four times the population of the U.S., it will likely take many more years for China to approach the U.S. – or any developed country – as far as GDP/capita.

Purchasing Power Parity (“PPP”)

“Purchasing Power Parity” is another important concept when considering GDP, because it considers the cost of goods and services in a country, not just the production of such goods and services in isolation. PPP makes adjustments to GDP/capita by looking at what each unit of US Dollar equivalent in a given country can purchase as far as a basket of goods and services. Prices of things are higher than average in some countries, and lower than average in others, and PPP attempts to adjust GDP/capita to reflect this.

The table to the right is from the IMF and shows GDP/capita estimated in 2020 by country, adjusted for PPP.


Perhaps one of the best examples that explains PPP in a simplistic sense is The Economist’s Big Mac index, which compares the cost of Big Macs in various countries around the world, adjusting the cost in local currency to (most often) US dollar equivalent. This is of course very simplistic, but interesting, because it expresses how expensive or inexpensive a Big Mac is country-by-country. For example, a Big Mac costs $6.57 in Switzerland but only $2.09 in Russia, and $5.51 in the U.S. and $4.75 on average in the E.U. This is another way to think about purchasing power parity, although when the concept is applied to GDP/capita, the gauge is of course used on a much broader basket of goods and services.

Conclusion

This is a taster for GDP, as economic term used frequently to gauge how a country is performing. Over time, the countries of the world have become more interconnected and their economies have become more correlated, especially larger countries with more diversified economies that increasingly trade with each other. In fact, as the saying goes, “when the U.S. sneezes, the world catches a cold”, because the health of the world’s largest economy is an important barometer of global economic growth. The same of course can be said for China, a low-cost producer and large exporter, compared to many other countries around the world including the U.S. and Europe. If you haven't had enough and would like to dig deeper as far as GDP, more granular source data can be found on websites for the Bureau of Economic Analysis (U.S.), Eurostat (EU/Eurozone), The Ministry of Foreign Affairs for Japan, the Office for National Statistics (U.K.) and the National Bureau of Statistics of China.

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